Fintech Banking Doomed To Disappear, But Customers Will Benefit

Federal Reserve Bank Board Chairman Jerome Powell (Photo by Chip Somodevilla/Getty Images)
Twenty years ago, or so, consumers had limited options for checking accounts: there was the choice between chartered banks or credit unions. Fast forward to today and consumers have a dizzying assortment of choices for transaction accounts. The traditional banks and credit unions are still the main options, and an entire industry of non-bank financial technology (fintech) providers has arisen.
The heyday of fintech has likely come to an end, as I covered in a previous article published earlier this month, and on balance, that is probably best for consumers. Time for fintech to change.
Fintech companies require partner banks to provide access to the banking system, and banks are exiting the business of partner banking. Without banking relationships these firms may not be able to continue.
Fintech companies tend to have snappy names, perhaps chosen to distance themselves from what they perceive to be the stodgy traditional financial services industry. Mercury, Yotta, Fold, Juno, Brex, Copper, and YieldStreet are just a few examples of fintech firms.
These firms are not banks, but in order to provide their products and services to customers the firms themselves must become customers of a chartered bank. The fintech firms are simply inserting themselves between the end customers and the actual banks. The arrangement where a bank provides a fintech firm with access to bank products is commonly called Banking-as-a-Service.
The customer-facing fintech firms therefore offer banking-like products, but they are not banks. Customers may not understand that they are not directly dealing with banks insured by the Federal Deposit Insurance Corporation (FDIC), and in some cases exploiting that confusion may be part of the fintech marketing model.
Fintech firms are not subject to the same safety and soundness standards to which Americans are accustomed in the traditional banking industry. The lack of regulation can have devastating consequences for their customers if these firms get into trouble.
Synapse Financial Technologies Inc. logo (Photo Illustration by Pavlo Gonchar/SOPA … [+]
In April 2024, a service provider to the fintech industry, Synapse Financial Technologies, filed for bankruptcy and materially impacted both the fintech firms and the end customers. Even six months after the bankruptcy filing there are still customers who do not have access to their money, and with what appears to be missing funds it is an open question whether customers will ever have all their funds returned.
It was fairly common practice for fintech companies to display the FDIC name and logo on their websites and in their marketing materials. Those critical of the fintech industry may characterize that usage as misrepresentation by omission. Customers in the Synapse bankruptcy case have informed the court that they believed their accounts were insured, and they could not understand why they could not access their money. Jason Mikula has reported extensively on the debacle in FinTech Business Weekly.
The FDIC is a remarkable asset to the U.S. banking industry. The FDIC provides depositors insurance against the failures of banks, and as reported on the FDIC website, since FDIC insurance began in 1934, no depositor has lost a single penny of insured funds due to bank failure.
For a fintech to claim the presence of FDIC insurance is a bit of a stretch.
Two members of the Senate Banking Committee, Senators Elizabeth Warren (D-MA) and Chris Van Hollen (D-MD), have asked banking regulators to restrict use of the FDIC name and logo by non-bank entities.
The FDIC only insures against the failure of a bank, and not the failure of a fintech intermediary. Therefore, as long as the bank continues to remain in good condition, if a fintech fails customers are potentially completely exposed should the customer’s funds not have been properly secured. This is what appears to have happened in the Synapse failure.
Customer funds deposited in a fintech, which are then placed in a bank, may not even be covered in the event that the bank fails. The insurance relied upon in such an occurrence is the FDIC pass-through insurance, and there are conditions that must be met for such insurance to apply. Customers of fintech entities are therefore not even guaranteed insurance in the highly unusual event of a bank failure since the customer is relying upon the fintech firm to maintain all the conditions for pass-through insurance.
The Rise of Fintech
Fintech companies grew alongside the internet and satisfied the customer demand for a high-quality customer experience in the electronic delivery of banking services. While banks concentrated on management of credit exposure, liquidity management, interest rate management, and all the other crucial aspects of the business of banking, for the most part fintech firms dedicated their resources to the customer experience. Banks were usurped in their core function of deposit gathering and transaction accounts.
In general, fintech companies concentrated on the customer experience and considered the other aspects of banking as mere infrastructure. Through that dedication of resources to only one aspect of the business, it should be no surprise that fintech companies were able to be more innovative than banks that had to consider the entire spectrum of operating a bank.
Part of the reason for the rise of the fintech economy was rooted in regulatory arbitrage. Simply put, banks and fintech firms have not been competing on a level playing field. Banks are heavily regulated by the government and must comply with strict rules and guidelines including capital requirements, lending standards, and consumer protections. The banks are also saddled with considerable burdens for compliance that the fintech firms have thus far mostly avoided, and the penalties for technical failures are disproportionately larger for banking firms.
There was also a strong financial incentive for the growth of the fintech industry. Anyone who has spent a career in banking will relate that while it is possible to have a great career and a comfortable lifestyle, growing wealthy, becoming rich, is not generally within the realm of possibilities.
Fueled by the venture capital and Silicon Valley ethos of seeking to change the world and making money while doing so, the startup world beckoned to those driven individuals who recognized the growing divide between consumer expectations and bank delivery of financial applications.
The financial technology industry can perhaps be characterized as having more failures than successes. The entrepreneurs who founded many of the companies simply did not have the experience or knowledge to understand the financial services industry, and they encountered problems in all aspects of the business. Customer acquisition, financial management, and most importantly, regulatory and compliance issues, have tripped up even experienced businesspeople not intimately familiar with the financial services industry. There are even a few public companies in the digital asset and brokerage space that are now successful but had a number of stumbles along the way.
Time To Change
Banks have important roles in the financial ecosystem far beyond that of technical infrastructure and access to payment rails. The global financial regulators have agreed that banks must serve as gatekeepers and protectors of the financial system. The banks are required to comply with the Bank Secrecy Act and help prevent money laundering, terrorist financing, and other financial crimes. Banks can only meet those objectives by knowing and understanding all customer activity.
Banks who worked with fintech companies typically provided each fintech with a single account at the bank where all of the fintech customer funds were comingled. Called a “For Benefit of” (FBO) the fintech customer account, the banks generally never knew individual customer balances within the FBO account and relied upon the fintech firms to maintain the accounting ledger.
The usage of FBO accounts was driven by economics, and most likely in two main areas.
First, there are likely no banks in the USA that own their core banking software. Instead, banks license software and pay the vendor a monthly fee for each account. The business model of fintech companies requires minimizing expenses and paying a bank a monthly fee for each customer would impact the fintech financial performance. Plus, some fintech firms target lower value customer accounts, and a monthly bank fee may make such customers unprofitable.
Second, fintech companies oft times have conducted their own customer onboarding and activity screening. For example, a fintech may have optimized the processes for signing up a customer, including what is commonly referred to as know-your-customer requirements. Through the usage of an FBO account the bank did not necessarily participate in the due diligence activities regarding customer acquisition.
Those two areas of cost savings for the fintech companies have precipitated regulatory enforcement activities against the banks. The consequence of regulatory action has been so significant that some banks are exiting the business of working with fintech firms completely, and other banks have severely curtailed such activities. Fintech firms may not be able to maintain banking relationships, and new fintech entrants may not be able to find a relationship at all.
In the future it is likely that banks will no longer be permitted not to have a full understanding of the ultimate beneficial owners of the funds in an FBO account. In a unanimous vote, in September 2024 the Board of the FDIC approved a proposed rulemaking on Requirements for Custodial Deposit Accounts with Transactional Features and Prompt Payment of Deposit Insurance to Depositors. If banks are required to know that information with certainty, then any system that maintains those balances outside of the bank’s own core systems presents the bank with risks and expenses. It would seem prudent for banks to discontinue offering FBO accounts and to require each customer to fully onboard in the bank systems. Direct onboarding customers with a bank is possible today for fintech firms, but it is often avoided given that the fintech would incur additional banking fees.
Banks are also under considerable scrutiny for their compliance with anti-money laundering regulation. Full compliance with the requirements by a bank is difficult, if not impossible, without full transparency into the customers and their activities. To ensure compliance banks should not be outsourcing these activities to a fintech, and instead should take full ownership of the process and technology. Such a change will necessitate overhauls in the manner in which most fintech firms operate.
What Comes Next
The banking industry must be in the leadership position when it comes to financial innovation. As participants in a highly regulated industry the banks are expected to be managed safely, provide uninterrupted customer service, and to be fully in compliance with all applicable regulations.
Banks should stop permitting fintech companies to escape the full cost of providing services through FBO-type arrangements. Banks must recognize that their value is far more than that of a mere infrastructure provider and charge accordingly.
Standalone fintech companies are not expected to disappear, however. The financial upside and the venture capital investment interest is simply too large for that to be a possibility in the short term. On the other hand, the financial technology industry should expect significant upheaval in the medium term as banks exit the business of working with fintech firms. There should be every expectation for massive change extending from fintech firms shutting down when they cannot find a banking provider to the emergence of more robust bank-fintech partnerships.
Fintech companies should be seeking to find banks to engage in joint-ventures. Banks should identify ideas, technologies, and teams for which they wish to be associated, and to enter strategic discussions. The economics need to be fair, however, and that means that the banks should receive significant participation in the upside. The banks should take the lead in these ventures for management, compliance, and ensuring safety & soundness.
The fintech firms that do not move quickly to secure banking relationships beyond that of account provision are likely to find out that no matter how great they are at technology or providing a unique customer experience, their value without a bank may be zero.
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